Would the U.S. economy benefit if the Federal Reserve took deliberate action to increase the rate of inflation? That is the question addressed in a very recent and widely discussed article from the New York Times. The article quotes numerous business leaders and policy analysts, all of whom make interesting and valid points. Most significantly the article reminds us of several important lessons provided by modern macroeconomics. These lessons can help contribute to the success of the Fed’s monetary policy strategy, both in the short term and over the long run.
Logic tells us that higher inflation is unlikely to have any enduring, positive effects on an economy. When inflation runs higher, businesses are able to increase the prices of the goods and services they produce and sell at a faster rate. But, when inflation is higher, workers demand higher wages—they need more pay to keep up with the rapid rise in cost of living. So, firms’ profits go up, but no business or business owner is really made better off.
Likewise, when inflation is higher, workers’ salaries increase at a rapid pace. But, the prices of all the goods and services go up as well. In the end, the increase in wages simply gets matched by higher prices at the store—no worker or consumer is better off either.
Finally, when inflation rises, consumers and businesses who borrowed in the past get to repay their loans with “cheaper” dollars. In that sense they do benefit from inflation. But what about those who have saved, instead of borrowed? Their wealth gets eroded by higher prices—they are made worse off.
This is one of the most important lessons that modern macroeconomics teaches us. In the long run, at best, inflation is a zero-sum game; at worst, it is the source of arbitrary and unlegislated redistributions of wealth. No one in a democracy who supports the rule of law should ever support policies that deliberately give rise to a sustained increase in price inflation.
These arguments show that inflation can be harmful in the long run. However, experience shows that higher inflation can, at least temporarily, work to increase economic growth and decrease unemployment. The inverse short-run relation between inflation and unemployment—the famous Phillips curve—is, after all, one of the most enduring statistical relations in all of macroeconomics. Similarly, focusing only on the short run, lower inflation is often associated with sluggish growth and higher unemployment.
How does one reconcile these two contrasting views of inflation: unambiguously bad in the long term but potentially helpful in the short run? The answer to this question was provided in work that macroeconomists like Robert Lucas and Thomas Sargent—both Nobel Laureates—did when they laid foundations for the 1970s so-called “rational expectations revolution.” For Lucas and Sargent, the key is whether or not the inflation is anticipated by businesses, workers, and consumers before it actually happens.
When a change in inflation is expected all prices and wages rise in lockstep, leaving output and unemployment unaffected. This is why, in the long run, “money is neutral.” A systematic change in the money supply designed to bring about a systematic change in inflation usually fails to bring about the decline in unemployment that would otherwise be predicted by the Phillips curve relation.
When changes in inflation take everyone by surprise, the short run Phillips-curve effects can be substantial. Some prices rise rapidly while others remain fixed. As customers purchase more goods with “sticky-prices,” firms respond by hiring workers and producing more.
Likewise, for many workers, wages remain fixed in the short run. When prices rise while those wages remain unchanged, firms in those industries hire more workers and producing more goods—the Phillips curve relation re-emerges for a while. Yet, as Lucas and Sargent emphasized, the positive short-run effects of inflation on output and employment must ultimately fade. As soon as all prices and wages have time to adjust, money will again be neutral.
Lucas and Sargent’s insights show why those quoted in the Times feel the way they do. Early last year, the Federal Reserve announced, for the first time in its 100-year history, an explicit two-percent inflation target. Yet inflation has fallen consistently below that two percent target. In fact, as data plotted by the Times and reproduced in the graph below highlight, going all the way back to mid-2008—that is, from the start of the recession through the entire recovery so far— inflation has almost always been below two percent.
What observers in the Times are seeing, indirectly, is that contrary to popular opinion, Federal Reserve monetary policy has not been inflationary or excessively stimulative in recent years. As I explain in more detail elsewhere, since 2005 the Federal Reserve has failed to allow for sufficient growth in broad measures of money supply. This slow money growth, and the unexpectedly slow inflation that it brought with it, probably contributed, first in 2008 to the severity of the recession and more recently to the sluggishness of the recovery.
But modern macroeconomics tells us the solution to the woes cited by commentators in the Times lies not so much in creating more inflation—say, by raising the rate that is targeted—as it does in creating more stable, predictable inflation that comes closer to the two percent target that the Fed, much to its credit, has already announced.
The confirmation hearings for Janet Yellen as Federal Reserve Chair provide us with an opportunity to speak clearly about our own priorities for one of the most important components of macroeconomic policy. By emphasizing that, first and foremost, we expect the Federal Reserve to hit its pre-announced two percent inflation target, we can provide Dr. Yellen with the political support she will need to hold the line: to bring inflation back to target whenever it threatens to rise too high or fall too low. By supporting the two percent inflation target, we advocate policies that best provide for healthy and stable macroeconomic growth, both in the short run and over the long haul.
Peter Ireland is a Professor of Economics at Boston College and a Member of the Shadow Open Market Committee